Back in 2009, mortgage lenders shot down proposed legislation by the Obama Administration to allow strip-down of residential mortgages for homeowners in Chapter 13 bankruptcy due to the adverse effects that it would have.

Now five years later, the Federal Reserve Bank of Philadelphia is arguing that lenders were wrong.    

A mortgage strip-down reduces the principal of underwater residential mortgages to the current market value of the property for homeowners in Chapter 7 or Chapter 13 bankruptcy. If a bankruptcy judge is granted mortgage modification powers, than it stands to reason an interest deduction could be implemented on top of the principal reduction.

The legislation was proposed in 2009 as a means of reducing foreclosures during the recent mortgage crisis.  And according to a new paper from the research department with the Philadelphia Fed, introducing mortgage strip-downs would not have strong adverse effects on mortgage loan terms and could be a useful new policy tool to reduce foreclosures.

The paper titled, “Using Bankruptcy to Reduce Foreclosures: Does Strip-Down of Mortgages Affect the supply of Mortgage Credit?” sought to determine whether allowing bankruptcy judges to modify mortgages would have a large adverse impact on new mortgage applicants.

And when looking at the results, it doesn’t.

“It appears that the market response to mortgage strip-down lacks a systematic pattern — it differs for Supreme Court versus lower-level courts, it differs depending on whether mortgage strip-down is allowed?under Chapter 7 versus Chapter 13, and the direction of change is not always in the predicted direction,” the paper said.

Positive impacts of the legislation include:

• Lenders would not be harmed because they would receive as much as if they foreclosed, and homeowners would be made better off because they would not be forced to move.
• Mortgage strip-down would reduce an inefficiency in the mortgage market: Lenders foreclose too often because some of the costs of foreclosure are externalized. For example, nearby homeowners bear part of the cost since foreclosed homes cause blight and reduce property values in the neighborhood.
• Another argument is that using mortgage strip-down to reduce household indebtedness would speed up economic growth by cutting household debt and raising household spending levels.

However, lenders like the Mortgage Bankers Association strongly opposed the legislation since it would “erode creditor protection by forcing lenders to give up one of their most important contractual remedies for default, and this may cause lenders to reduce the supply of mortgage credit."

The MBA said allowing mortgage strip-down in bankruptcy would raise mortgage interest rates by at least 1.5 percentage points, which would amount to a huge increase of 30% or more. That's higher costs for new homeowners, higher costs for mortgage lenders.

In response the Philadelphia Fed found like that mortgage markets responded to the Supreme Court decision to abolish mortgage strip-down in Chapter 13 bankruptcy by increasing approval rates for mortgage applications and reducing interest rates on new mortgages, but the changes were uniformly small.

The data uses a series of U.S. Court of Appeals decisions during the late 1980s and early 1990s that introduced mortgage strip-down under both bankruptcy chapters in parts of the U.S., followed by two Supreme Court rulings that abolished it throughout the U.S.

The results showed that approval rates rose by 0.9 percentage point, or 1.1%, and interest rates fell by 23 basis points, or 3.4%. When the Supreme Court abolished mortgage strip-down under Chapter 7, approval rates fell by 1.5 percentage points, or 1.8%, the opposite direction from our predictions. It also found that markets responded little to decisions by lowerlevel federal courts to introduce mortgage strip-down.

“Overall, our results suggest that lenders respond to forced renegotiation of contracts in bankruptcy, but their responses are small and not always in the predicted direction,” the paper said. “The lack of systematic patterns evident in our results suggests that introducing mortgage strip-down under either bankruptcy chapter would not have strong adverse effects on mortgage loan terms and could be a useful new policy tool to reduce foreclosures when future housing bubbles burst.”